While smart beta is often treated as a new investment buzz term, the truth is the idea of weighting equity benchmarks by methodologies other than market capitalization has been around for several decades. For example, equal-weight and weighting stocks by value or growth traits are not new ideas.

However, there are new concepts in the world of smart beta, including multi-factor funds. Widely documented is the fact that smart is a significant growth engine for the broader exchange traded funds (ETFs) industry and within smart, multi-factor funds are proving to be important growth catalysts.

“Multi-factor ETFs are marketed as a way of improving investor return profile by addressing the risks inherent to single-factor smart beta funds,” according to Morningstar research. “We are seeing an evolution in product development on this front. The first batch of multi-factor ETFs tended to follow an equal-weighted approach to combining several factors.”

Why Multi-Factor ETFs Are Taking Off

One of the most important reasons behind the multi-factor ETF boom is also one of the easiest to explain. Historical data indicate that, from year-to-year, different individual investment factors shine while others lag. While the value is often a winner over the long-term, value stocks are being trounced this year by growth and momentum equivalents.

Likewise, with equity market volatility benign, the low volatility and quality factors are not delivering extraordinary returns in 2017. However, factor performances are subject to change and without notice. That makes timing entries and exits from specific factors difficult, a burden that is not an issue with multi-factor ETFs.

Some multi-factor ETFs provide exposure to the growth, low volatility, quality, small size and quality factors under the umbrella of one ETF. Of course, different issuers offer different views on multi-factor strategies.

“In our approach, therefore, we essentially look to distribute risk more evenly spread across regions, sectors and stocks by balancing the market-cap index’s inherent concentrations,” said JPMorgan Asset Management. “As uncontrolled risk concentrations are unlikely to be rewarded over the longer term, we believe investors should strive for maximum diversification when constructing a core equity exposure. Redistributing these risk weightings can lead to potentially less volatility in down markets and an overall smoother experience for investors.”

The JPMorgan Diversified Return U.S. Equity ETF (JPUS) weights screens stocks for favorable momentum, quality and value traits and then weights components by inverse volatility, meaning the least volatile stocks receive the largest weights in the fund. In 2017, the strategy is working as JPUS is outperforming the S&P 500 by about 150 basis points.

A Different Feel

Advisers and investors that are new to multi-factor ETFs are apt to quickly realize that these products feel different than traditional, pure beta, cap-weighted funds. Cap-weighted funds come with drawbacks, including single-stock risk and exposure to potentially overvalued names.

Conversely, some multi-factor ETFs, though passive, actively mitigate those risks along with sector factor-specific risks. Advantages like those explain why there are close to 300 multi-factor funds trading in the U.S. with over a third having debuted in the past two years.

“CFRA Research expects advisors and investors will further seek out multi-factor ETFs that feel more like active management than S&P 500 index-based ETFs and market-cap weighted peers, but are cheaper than the 1.1 percent expense ratio for a large-cap mutual fund,” said CFRA Research Director of ETF & Mutual Fund Research Todd Rosenbluth in a note out earlier this year.

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